3rd Quarter – Diversification: Easy in Theory, Difficult in Practice

October 10, 2018

One of the core tenets of any proper investment strategy is diversification. People often describe diversification using the familiar saying, “Don’t put all your eggs in one basket.” Although the phrase has been used to the point of overuse, it nonetheless manages to capture the essence of why it is wise to diversify.

Diversification means owning a variety of different holdings that perform well at different times. It sounds easy in theory, but in practice, the frustrating part of diversification is that investors can sometimes feel like they own too many of the recent losers and not enough of the recent winners. When an asset class performs well, whether it is technology stocks in the late ‘90s, emerging markets and real estate in the mid-2000s or U.S. stocks in 2018, the temptation is to chase the best sector. This is why diversification is so easy to agree with in theory but difficult for many investors to practice.

Diversification lowers the overall risk of the portfolio. As some holdings decline, others will advance, reducing the chances of severe losses by being overinvested in a single holding or asset class. Diversification can also increase expected returns by being able to rebalance away from those asset classes that are doing well (selling high) and investing more in those asset classes that have become relatively cheaper (buying low). By driving more return for each unit of risk and less risk for each unit of return, diversification increases portfolio efficiency. For these reasons, diversification is the cornerstone of proper investment management.

There are times when being diversified is comfortable and the markets make the benefits of diversification rather obvious. For example, in 2017, international and emerging market stocks significantly outpaced U.S. stocks. For U.S. investors, having globally diversified portfolios felt good because of the returns of international and emerging market equities (see Chart I below).

This year, the situation reversed, and diversification became frustrating as U.S. markets moved steadily upward while international stocks and emerging markets lagged. This is the point at which some investors would panic and change their investment strategy, even though the process is working exactly as it should. Diversification doesn’t work if everything goes up and goes down at the same time. The benefit of diversification is only realized if asset classes move up and down at different times, allowing portfolios to rebalance, and to also be less risky than individual asset classes on their own.

Chart I: Forum GNP Core 60 Holdings

Without a disciplined process, investors frequently find themselves acting with emotions in the lead. They want to buy more of what has gone up and own less of what has gone down (buying high and selling low). That is why investors were hurt with concerns about Japan in the 1990s, tech stocks in the early 2000s and emerging markets and real estate during the financial crisis.

From 2010–2017, the U.S. market has been the leader and returned 13.97% per year while international stocks have only returned 6.01%.2 While this U.S. performance has been very good for global portfolio returns, investors with a diversified portfolio may see this outperformance and wish they held more U.S. stocks and held less of everything else. But discipline and history tell us the right thing to do (and the hardest thing to do) is to sell some U.S. exposure and buy international exposure to bring portfolios back in line. As Warren Buffett famously said, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”3

Another question that comes up from time to time is whether we can conclude from the last few years that U.S. stocks have a generally higher expected return. We only have to go back to the eight years before 2010–2017 (for an equivalent period) to see the exact reverse. From 2002–2009, U.S. stocks returned 2.61% annually and international stocks returned 7.05% per year.4

Looking back even further, since 1970, U.S. stocks have returned 10.52% annually and international stocks 8.94% annually, with U.S. stocks ahead 25 of the 48 years and international ahead 23 of the 48 years.5

In the 1970s and 1980s, international stocks did better while U.S. stocks outperformed in the 1990s (see Chart II below). International stocks may have performed better than U.S. stocks in the 2000s but so far in this decade, U.S. stocks have notably outperformed international stocks.

Chart II: Periodic Returns Over the Decades6

It is important to recognize that a diversified portfolio kept investors from being overexposed to the wrong asset class at the wrong time. For example, U.S.-only investors in the 2000s who were at or near retirement impaired their lifetime retirement income by not being diversified.

When we look at the academic evidence, the benefits of diversification are clear. Investors should have the right amount of exposure to all global markets. However, when we are living through years when diversification feels bad, it is much harder to remember to focus on the big picture and resist the temptation to try something different. Diversification and discipline are easy in theory, difficult in practice.

Please contact your advisor if you would like to have a conversation about recent market activity or to review your portfolio.

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